Special Economic Zones have become a global phenomenon due to their role in driving economic growth and facilitating foreign direct investment. In the UAE, free zones operate under special regulations, offering various advantages such as efficient infrastructure, full ownership, profit and capital repatriation, and exemption from corporate tax. However, it is important to understand the conditions and requirements for maintaining the corporate tax exemption.
These concessions apply to ‘qualified free zone persons,’ which include non-resident branches in free zones that meet certain criteria:
1. Maintain sufficient substance.
2. Generate qualifying income.
3. Elect the 0% tax rate.
4. Comply with transfer pricing regulations for transactions with related parties.
Prepare and maintain audited financial statements.
5. Additionally, the non-qualifying revenue of such qualified free zone persons should not exceed the de minimis threshold, which is lower than 5% of total revenue or AED 5M.
Qualifying income of a qualified free zone person is subject to a 0% tax rate, while non-qualifying income (including income from excluded activities) within the de minimis limit is subject to a 9% tax rate.
It is worth noting that income from a domestic Permanent Establishment (PE) and income from immovable property in certain cases are separately taxable at a rate of 9%.
If a qualified free zone person breaches the de minimis threshold, they lose their tax holiday status for five tax periods, including the year of failure, and become liable for a 9% corporate tax like a regular taxpayer, according to Gulf News. The UAE Cabinet decision has clarified most aspects of the tax holiday provisions for free zones, but some issues still require addressing for greater certainty.
Exclusions from qualified free zone persons
•Freelancers and individuals working under licenses issued by a free zone authority (FZA) are not covered.
•It is unclear whether ‘natural persons’ refers only to individuals or also includes sole proprietors.
•Support service providers in the free zone may be affected as they interact with individuals, and further guidance may be required.
Issues regarding the distribution model:
•Initially, it was unclear whether the condition ‘in or from designated zones’ for qualifying activity applies to the location of the distributor or the location of the goods.
•Concerns were raised about whether the 0% rate would apply in bill-to-ship-to models where goods do not physically move in and out of the free zone.
In a recent public awareness session conducted by the ministry, it was clarified that qualified free zone persons (QFZPs) engaged in distribution activities, where the title of goods is transferred, will be considered as operating “in and from” a designated zone, even if the goods are not physically moved.
This means that such distribution activities will be considered as qualifying activities, and the income generated from them will be eligible for a 0% tax rate. However, the qualifying activity of distribution does not specify the source of goods procurement. It remains unclear whether goods sold in or from the designated zone can be sourced from a supplier in the mainland.
Moreover, trading activities from designated zones only cover sales to wholesalers or retailers, excluding sales to end consumers. It is important to assess the risk of permanent establishment for entities that have employees working outside free zones, agents, and directors who negotiate and finalize contracts outside free zones. While certain activities can be outsourced within a free zone, it is essential to ensure appropriate supervision to meet economic substance requirements. The decision to forgo the 0% tax benefit should be carefully considered.
If a QFZP opts for the 0% tax rate, it cannot be part of a tax group. When engaging in transactions with other free zone persons, the recipient must be the beneficial owner of the goods or services. In other words, the recipient should have the right to use and enjoy the goods or services, rather than merely passing them on to another party.
To minimize any uncertainties, it is crucial for taxpayers to seek additional clarifications from the Federal Tax Authority (FTA). To fully maximize the tax advantages, it is necessary to assess the overall business activities of QFZPs. It should be noted that apart from the corporate tax benefits, free zones also provide concessions in terms of VAT, customs, and excise taxes. Each relevant law has its own distinct set of conditions.
Hence, it is crucial to perform a thorough compliance assessment that covers all tax regulations, free zone decree bylaws, and Economic Substance Regulations (ESR). According to the OECD Pillar 2 proposals, certain multinational enterprises operating in UAE free zones may also face the possibility of being subject to a higher corporate tax rate. However, we are still awaiting the legislation for further analysis.